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Navigating through a seemingly bullish Sri Lankan equity market

By Taamara de Silva

January 31, 2021

The Sri Lankan equity market performed exceptionally well recording a rise in the All-Share-Price-Index (ASPI) of 80.5 per cent in 2021 compared to the previous year. The annual gain was the highest return recorded since 2010 and was identified as one of the highest yielding indices in the region. Despite being viewed very positively by the investor community, there is a looming concern; could this be a scapegoat to a fragile economy teetering on the brink of collapse?

Since November 2021, Moody's, Fitch and Standard & Poor's ratings agencies have all downgraded Sri Lanka on debt default concerns and even though the Central Bank of Sri Lanka (CBSL) was able to repay USD 500Mn towards an international sovereign bond, this is only the first tranche of a total of USD 4.5Bn that needs to paid back this year.

No adjustments to fiscal policies (which includes variables such as taxation and government spending) or monetary policies (interest rates and inflation) is able to revive the economy out of crisis. Inflation is running at a decade-high, amid surging commodity prices and achieving the fiscal deficit target of 8.9 per cent of gross domestic product is a struggle.

Yet the bull run on the stock market continued into 2022 as the market index gained 7 per cent in the first three days of the year breaching its previous all-time high and the market capitalization crossed LKR 6.0Tn (6,000Bn) for the first time in history. However, Colombo's rally may run out of steam very soon when the CBSL starts to raise interest rates to cope with rising inflation or seeks assistance from the International Monetary Fund (IMF) as a last resort to its deteriorating foreign reserve position.

What has led to this boom on the stock market?

From an economic standpoint, the boom has been triggered by monetary and fiscal measures: increased money supply (liquidity) in the economy, low interest rates, stimulus packages given to businesses, various tax reductions and exemptions.

Investors too have limited options as investments in fixed deposits continue to yield negative returns. The property market is stagnant due to a drop in rentals, overall increase in construction costs and inability to liquidate investments in a hurry and gold being among the other alternatives that are passive and long term in nature.

A multitude of retail investors including millennials have entered the market as evidenced by the number of stock trading accounts that have increased by six-fold Year-on-Year fueling euphoric market sentiment.

Previously low-profile shares that were trading at low P/E multiples have gained favor as new investors trade tips via messaging apps and chat groups. Further, an increase in informed trading decisions has improved the efficiency of the market and reduced the asymmetry of access to information.

Commercial banks too have shored up their lending, specially to large corporates and High Net worth Individuals (HNWIs) via margin trading facilities and we can assume that portion of this lending has been redirected to the stock market.

A hedge against inflation

An overall increase in commodity prices, led by global supply shortages and higher logistic costs, and rampant money printing has resulted in inflation. According to available data, from December 2019 to October 2021, CBSL has printed approximately LKR 2.8Tn. The government mainly uses this money to pay for the infrastructure drive and it will trickle into the economy mainly via large corporates and high net worth individuals resulting in widening the gap between the rich and poor. A relief package of LKR 229Bn was approved recently and this too will continue to fuel inflation going forward.

In such a scenario, investments can pour into listed companies as investors try to hedge themselves against inflation which is what we see happening.

Protection against Rupee Depreciation

Sri Lanka faces a chronic foreign currency crisis, through repeated cycles of borrowing since 2007, has piled up USD 11.8Bnworth of debt through International Sovereign Bonds (ISB), which makes up the largest part (36.4 per cent) of its external debt.

Fitch estimates that approximately USD 2.4Bn is required for state-owned and private firms in the country to honor the debt obligations they have in 2022, over and above the USD 4.5Bn central government debt. The country also needs around USD 20Bn for essential imports such as fuel, food and intermediate goods for exports.

This means that sooner or later, the currency could depreciate substantially resulting in a massive demand for dollarized counters. We have accordingly seen a strong appetite for export-oriented companies that could benefit from this scenario.

Points to ponder

Interestingly, the sharp rise in the market has been driven by just a few large companies like Expolanka, Lanka Orix Leasing Company (LOLC), Brown & Company PLC and Hayleys group shares while traditional blue-chip counters like Nestle Lanka PLC (NEST), Ceylon Tobacco Company (CTC) and John Keells Holding (JKH) have remained obstinately passive.

To add to the woes, there was significant sale of equities by foreign investors on the stock market, increasing the net outflow in 2021 to over LKR 51Bn that signaled profit realization from foreign investors and institutions while retailers and new market entrants continued to absorb these shares.

It has been observed that most illiquid counters have recorded steep appreciations exceeding 200 – 300 per cent even though their Net Asset Values (NAV)s have remained constant if not increased marginally.

While the capital markets community experienced a lucrative year due to higher turnovers, resulting in increased brokerage income, there has been a strong effort by market participants to encourage day trading. Intraday price fluctuations reaching up to 25 per cent have created a massive swing trading opportunities for the watchful investor.

Strategies for investors to secure and enhance their gains

Investing in an already inflated market has its pros and cons. Entering speculative counters at all time high prices without being able to justify earnings or fundamentals can have severe repercussions. Market manipulation in varying degree and panic selling has resulted in substantial losses, especially for amateur investors time and again, reiterating the importance of taking calculated risks that can suit one’s risk/return profile.

However, for the intelligent investor who relies on fundamentals, practicality and proper timing, it has never been a challenge. One approach is to identify the sectors in the economy that are set to benefit from macro-economic trends

Import restrictions have incentivized local production and manufacturing sectors in addition to companies with access to export markets - the tile, cable & aluminum sectors to name a few. Further, a boost in agriculture, dairy and plantation sector companies are potential counters to watch considering the global demand for commodities like palm oil, tea, rubber and spices.

Overall, fundamentally strong companies with dollarized earning will stand out and it is wise to bid time for a market correction and collect these shares as they have logically appreciated, but may not stay in portfolios of investors who do not command holding power.

However, if Sri Lanka is unable to achieve a significant economic growth, companies will not be able to maintain their performance and growth. In such a situation, further healthy increases in share prices and payment of dividends will not be possible. Yet, a long-term view, diversified portfolio approach and investment tailor made to suit the risk / return profile can go a long way in navigating the stock market!